China's deflation risk is growing and foreign central banks are on alert

A customer pushes a cart at a supermarket in Fuyang Thomson Reuters WELLINGTON/BEIJING (Reuters) - The risk China's economy enters deflation is growing, data suggested on Wednesday, as signs emerge that some foreign central banks are increasingly worried about the impact falling Chinese prices and a weaker yuan could have on their economies.

New Zealand's central bank governor Graeme Wheeler said that China's surprise devaluation of the yuan, or renminbi, last month had left them concerned about the risk they may let it slide further.

"We've seen authorities basically say they want to stabilize the renminbi, but if there were to be a very substantial depreciation in the renminbi it would certainly export deflation around the rest of the world, so everybody is looking closely at China," he said at a press briefing following an interest rate cut in New Zealand.

The deflation threat was underlined by data showing that Chinese manufacturers cut prices at their fastest rate in six years, with the producer price index (PPI) down 5.9 percent in August from a year earlier, though consumer prices are rising for now.

A growing worry for overseas central banks like the Reserve Bank of New Zealand (RBNZ) is that falling Chinese factory gate prices coupled with a weaker yuan mean the price of exports from China will fall sharply, feeding downward price pressures into their economies.

Wheeler's comments came despite attempts by Chinese policymakers to reassure global markets that the yuan will remain stable and China's economic growth, whilst slowing, is still set to be around 7 percent this year.

"The RBNZ...verbalised it but this is probably an underlying concern shared by policymakers around the region," said Sim Moh Siong, foreign exchange strategist at Bank of Singapore.

Wheeler said his central bank's view is that the Chinese economy is actually growing somewhere between "5-6.5 percent at this point", a rare public comment by a central bank governor suggesting that China's growth is below where the country's policymakers say it is.

The slide in Chinese factory prices is not yet feeding into the consumer price index (CPI), which posted a rise of 2 percent in August from a year earlier, though the National Bureau of Statistics flagged that last month's gains were mainly due to soaring food prices, not an improvement in economic activity.

"The risk for China is still deflation, not inflation," said Kevin Lai, chief economist for Asia, excluding Japan, at Daiwa.

"PPI deflation will eventually filter down to affect CPI, and aggregate demand will continue to be weak," he added, noting that he's just cut his inflation forecast to -0.5 percent from 0.5 percent.

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REASSURANCE

Economists believe China's surprise currency devaluation of nearly 2 percent in mid-August will have little impact on inflation in the near term, with sharply lower commodity prices likely to be the main drag.

Since the devaluation, China has scrambled to stabilize the yuan as markets bet it may fall further, running down its foreign exchange reserves by a record amount in August to support the currency. Markets still believe it could fall further though, with the offshore yuan rate trading at a 1.3 percent discount to the managed onshore rate on Wednesday.

Chinese Premier Li Keqiang, for the second day running, used a speech to tell business leaders and investors on Wednesday that China does not want a currency war and that the slowdown in its growth rate will be modest. The economy grew 7.3 percent last year.

"China's economy will not see a hard landing" he told a gathering of the World Economic Forum in Dalian in northeastern China.

"Once there are signs of economy slipping out of the reasonable range, we will be fully capable of handling (the situation)."

The economic signs are gloomy. After Li spoke, the China Association of Automobile Manufacturers said auto sales in China in the first eight months of the year were unchanged from a year earlier, raising the specter of the market's first contraction since foreign carmakers started to focus on China over 25 years ago.

Global markets' worries about Beijing's handling of the economy and its currency have been exacerbated by China's attempts to stem the slide in its equity markets. Despite unleashing a barrage of policy measures to support stock prices and push out speculators, its equity markets have fallen around 40 percent since June.

The past two days though have seen Chinese stocks push higher, with the positive sentiment feeding into other major equity markets around the world. Still, that optimism was waning on Wednesday, with share prices back in the red.

The CSI300 index of the biggest stocks listed in Shanghai and Shenzhen was down 0.86 percent at 0633 GMT, while the Shanghai Composite Index was 0.83 percent lower.